Has Middle-Class Pay Risen As Much As It Should Have?

Scott Winship
, ContributorI assess the state of opportunity in America and ways to expand it.Opinions expressed by Forbes Contributors are their own.

Part 3 in the series, “Inequality and the Middle Class.” Also available: Parts 1 and 2

Back in January I wrote the first column in a series exploring how inequality has or has not affected the middle class. I promptly got caught up in otherprojects, but I want to return to my critique of the Economic Policy Institute’s “Wage Stagnation in Nine Charts” report. As I mentioned then, the EPI report is an exemplar of attempts to show that the middle class is doing poorly, and all because of income inequality. These accounts usually have a kernel of truth but dramatically overstate the problems of the middle class and the extent to which inequality has caused them.

In Part 1 of this series, I took on the claim that middle-class incomes would be higher by $18,000 if not for rising inequality since 1979. I argued that after accounting for the taxes and transfers on which we rely to reduce inequality, that figure drops to $13,000. But these computations assume that preventing the top five percent’s incomes from rising 40 percent over 28 years—lowering their 2007 incomes by $200,000 on average—would not have reduced the economy’s aggregate income growth. If it would have, then middle-class incomes would have risen by less than these figures suggest.

I showed that if capping top incomes would have reduced income growth rates by 0.23 points per year—where “income” includes realized capital gains in addition to the income reflected in GDP—then EPI’s “inequality tax” (after redistribution) would have been around $8,000. And if we assume that the actual policies that would have capped the incomes of the top five percent would have disproportionately raised the incomes of the rest of the top fifth of households, then it is easy, mathematically, to show that the middle class might not have benefitted at all from reining in the top five percent.

In short, EPI’s simple chart turns out to conceal some important assumptions that underpin its claim of an $18,000 “inequality tax.”

Even if rising inequality did come at the expense of the middle class (or the poor), there is a values question that is separate from the empirical question: should the middle class (or the poor) have seen stronger income growth? That’s where EPI’s second of its nine charts comes in.

EPI makes a normative argument about the proper income growth the middle class should have seen that is nearly universal on the left. This argument is never elaborated fully, and key assumptions go unstated. Workers, progressives believe, should be paid in accordance with the value of what they produce for their firms. (This belief, I would argue, is actually widespread among conservatives too.) According to progressives, there was a time when workers were paid fairly by this criterion (or at least less unfairly). But since then, productivity growth across the economy has outpaced growth in median incomes and wages. Therefore, today’s middle-class workers are paid much less than what they deserve. The reason for this divergence? Rising inequality. That was also the message from the Commission on Inclusive Prosperity, co-chaired by Larry Summers and Ed Balls, in a report published by the Center for American Progress.

I have taken on part of this argument before in these “pages.” In fact, compensation in the non-government, non-housing part of the economy has risen just as much as net productivity has. Net productivity subtracts depreciation—the cost to firms of replacing equipment, buildings, machines, and other capital—from GDP before dividing by hours worked. Depreciation is not income that goes to today’s worker or today’s business owner; rather, it increases future productivity, producing income for both tomorrow’s worker and business owner. Ignoring the housing sector is necessary because national income includes “imputed rent” to homeowners reflecting the benefits provided by an owned residence for which renters, in contrast, must pay. Imputed rent is tangential to the question of how closely workers’ pay is aligned with their value to firms. Finally, output in the government sector is measured badly, and at any rate, the allocation of income between workers and owners is about the private sector. My results have since been affirmed by Matthew Rognlie, whose study for the Brookings Papers on Economic Activity critiquing Thomas Piketty found that labor’s share of income has not fallen, which is equivalent to saying that compensation and productivity have tracked each other.

To be sure, the pay of the median worker has not kept up with net productivity. But for the progressive fairness argument to be compelling, it must be shown that the pay of the median worker has failed to keep pace with the net productivity of the median worker. We lack any data on this point and are unlikely to ever have any. It is possible, however, that the growth of productivity since the 1970s primarily reflects an increase in the productivity of workers making well above median pay—maybe even an increase concentrated in the top one percent.

In a forthcoming paper, I note that the average income in the top one percent rose three times as much as the average income in the middle fifth of households between 1979 and 2007. Might the productivity of the top one percent have risen by three times as much as the productivity of the median worker? It is not out of the question, given how globalized the economy has become. Attracting and retaining the most talented executives has likely become much more important for firms, and it has become much more important that the financial sector allocate capital efficiently. One only has to think about Major League Baseball to make these possibilities concrete. The top baseball players are worth far more to major league teams—and to the League as a whole—than the second tier of players. Their salaries reflect it—much more than they did in the recent past.

The other assumption that EPI and progressives make is that the baseline distribution of pay between the middle and the top was, in fact, “fair” by their own criterion. They assume that initially—the EPI chart starts at 1948—the median worker was paid in accord with his value to his firm, and that executives and shareholders were paid fairly too. (To be precise, they assume that the distribution of pay was fairer in 1948 than it is today, not necessarily that it was fair.) But it is also possible that this earlier distribution of pay was less fair than today by the criterion of paying people according to their productivity.

When the left talks about the top one percent receiving more income than it deserves, it often refers to “rents”—an economics term that describes income that would not be received if the economy were more competitive and efficient. But what if it was the median worker that benefitted from rents decades ago?

In the 1960s, the labor market remained organized primarily around married men, and the ideal of the male breadwinner was still widely shared. Betty Friedan’s The Feminine Mystique was published in 1963, when around 30 percent of married mothers worked. That was up from 20 percent in 1950 but well below the 70 percent level reached in the mid-1990s. Married women were actively discriminated against in this “male breadwinner” era, but the norm that married women should not work was probably widely shared among men and women alike.

It is also likely that this norm was shared among male executives and shareholders no less than among male workers. If so, then it is not unreasonable to think that many men were paid a “breadwinner premium” on top of the value they created for the firm, and that top earners received correspondingly less than their value to the firm under a more competitive system where married women worked much more. (In fact, the importance of the breadwinner premium for my argument is not so much its male-ness. Through much of the twentieth century, even in an egalitarian world, the middle class was not yet prosperous enough for families to send two parents into the workforce and afford the child care and other costs that entailed.)

As more and more married women entered the labor force—or increased their hours on the job—the logic of the breadwinner premium broke down. This occurred at the same time that increasing global competition made breadwinner rents less practical, and the influx of married women into the workforce itself put downward pressure on male pay by increasing the supply of labor. As the rationale for the breadwinner premium eroded, executives could be compensated more generously, in line with their actual productivity levels. The result would have been rising income concentration, declining pay disparities between men and women, and stagnant male pay, all of which correspond with observed trends.

If this is an accurate depiction of the evolution of pay since the 1960s or 1970s, then charts like EPI’s obscure the “unfairness” in pay during the baseline era from which they then display subsequent trends. That is, if pay should reflect productivity, then in this story we would expect median pay to rise more slowly than the productivity of the median worker, because it started out too high by the normative criterion progressives espouse.

Two more empirical facts are consistent with this argument, which is elaborated in forthcoming work of mine. First, from 1942 to 1974, median earnings were higher than what economy-wide productivity levels justified, assuming that in the late 1930s workers were being paid fairly—that is in accord with productivity levels. Put another way, median earnings growth outpaced productivity growth during the mid-1940s and then remained at this elevated level for twenty-five years. When EPI shows hourly compensation and productivity rising together from 1948 to 1973, that starts from a base year where the typical worker may have been doing better than productivity levels justified, a distortion that continued for a quarter of a century thereafter. It wasn’t until the early 1980s when median earnings growth began to permanently lag productivity growth—the same time that income concentration began to rise.

Of course, I can’t say for sure that in the late 1930s worker pay reflected productivity. It may be that pay was too low and the subsequent years corrected for this disparity. But it may also be that worker pay had already outpaced productivity growth even before 1937, and that with a baseline of, say, 1929, today’s median earnings are right in line with productivity growth since the 1920s. We can’t say, and that is the point—EPI cannot say that pay reflected productivity fairly in 1948 either.

A second fact consistent with the argument that recent gains at the top have increased fairness in pay—defined in terms of how well it reflects productivity—is the fact that individual income concentration is not nearly as high as corporate income concentration and was far less so even in 1979. The top one percent of households received 9 percent of income in 1979 and 19 percent in 2007. In contrast, the top two percent of corporations received 84 percent of corporate income in 1979 and over 95 percent in 2007. The percentage point increase was roughly the same whether looking at top individuals or top corporations, but concentration of corporate income makes individual inequality look insubstantial.

To wrap up, it is important to be clear between empirical facts and hypotheses. My analyses show that in the aggregate, pay and productivity have tracked each other well for over 60 years. EPI can’t really contest that point. EPI’s analyses show that median pay has not tracked aggregate productivity since 1948; I’d quibble with some details in their chart, but the finding is robust. What EPI can’t say is that the pay of the middle class and at the top was more in line with each group’s productivity in 1948 than it is today. That is a hypothesis that with some assumptions is consistent with the data. I can’t say that my alternative hypothesis that middle class workers in 1948 were paid more than their productivity levels justified describes accurately what has happened. I have provided some evidence in support of this hypothesis that is also consistent with the data. What I hope is clear is that seemingly simple and compelling charts are often anything but.

I’ll take on EPI’s third chart—on rising pay inequality since the 1970s—in my next column in the series. EPI is on firmer ground here, but it still ends up overstating the increase in inequality.